'Tis the Season -- For a Choppy Market

By

Michael Kahn

Aug. 13, 2003 4:34 p.m. ET

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WHILE SANTA MAY BE RELAXING in his summer retreat, the season for spinning wheels in the stock market is now upon us. The old Wall Street adage, "sell in May and go away," may not have produced a declining market, but it sure left the bulls with nothing to show for their troubles. Even if this year is an exception to that rule and the market does eventually break out, the sheer length of the market's current trading range has caused bulls and bears alike to question their forecasts.

Chalk one up for the market: Once again, it fooled as many people as possible.

There have been a number of positive economic reports released over the past week or two, including today's upbeat retail sales numbers. Job losses seemed to have slowed down and productivity is up -- all good for the economy. But is it really good for the stock market?

A Lehman Brothers report speculated that the rally off the March low was really a reflection of the data now being released. In other words, the discounting mechanism of the stock market was anticipating these improvements, which suggests that the stock market's recent three-month trading range anticipates a pause ahead for the economy.

But Getting Technical is not about predicting the economy. Here, we look at the technical underpinnings of the market to explain what might be going on.

And just what is the market telling us now? For starters, it is not so gently guiding us to the sidelines. With fledgling pattern breaks failing and unexpected reactions to news of all kinds, there is just no trend on which we can rely -- and that means it is a market for traders, not investors (see Chart 1).

CHART 1

Another important aspect of the August market is the low (and falling) volume on both the New York Stock Exchange and the Nasdaq Composite index. Some of the lowest volumes of the year were recorded over the past few days -- and that includes pre-holiday days and abbreviated trading sessions. Because liquidity is down, what might normally be an insignificant news event can have an extraordinary effect on stock prices.

For example, if Saddam Hussein is captured, the market could be off to the races. Why? With so few shares available (low supply), the increase in demand would force prices much higher, and even though it might be a temporary move the effects on bearish traders would be devastating.

So while we wait for vacation season to wind down and for trading season to ramp up again, it's a perfect time to look outside the stock market for clues to its direction.

One place to look is the bond market. Over the past two and a half years, there has been a strong correlation between ten-year Treasury yields and the Standard & Poor's 500, according to John Kosar, Senior Research Analyst for Bianco Research, LLC. Says Kosar: "Bonds had been taking their cues from stocks, but that relationship seems to have reversed since both stocks and bonds peaked in June. Bonds now seem to be in the driver's seat."

If Kosar is right, then the current decline in bonds is holding the stock market back and while a bounce in the bond market looks overdue, Kosar's long-term forecast shows a bear market there is just getting started (see Chart 2).

CHART 2

So what does this suggest for stocks? Well, the outlook is not that good, and this fits in with the theory that the 2000s are going to resemble the 1970s for stocks, where big cyclical swings dominate the action, but by the end of the decade prices will essentially be where they are right now.

For the shorter term, a bounce in bonds may lead to another move higher for stocks. In a Credit Swiss First Boston report, Rob Kepler, Director of US technical analysis, discussed the seasonal tendencies for bonds to rally between mid-August and mid-October. He cited another report by Moore Research Center saying that this seasonal effect had 10-year futures higher for 14 of the past 15 years, with the only exception being the very bad bond year of 1994.

Kepler added that other technical indicators are not in line with this seasonal tendency this year, so perhaps the size of the rally will not be up to average -- but that fits with the idea of a bounce rather than a bullish market.

Sentiment, open interest and commitments of traders indicators followed by Kosar agree that such a bounce is likely.

If all of this bond market action does still influence the direction of stocks, then there could very well be another small leg up for the stock market. But after that, rising interest rates may choke off further stock appreciation. Unless the economy can get going so that businesses can produce greater returns than the cost of money used to earn them (a.k.a. interest rates), stocks may be in for some trouble a few months from now.

Getting Technical Mailbag: Send your technical analysis questions to us at online.editors@barrons.com. We'll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn writes the daily "Quick Takes Pro" technical newsletter (http://www.midnighttrader.com). He is the author of two books on technical analysis, most recently Technical Analysis: Plain and Simple, and was Chief Technical Analyst for BridgeNews. He also is Director of Marketing for the Market Technicians Association (www.mta.org).

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